Large-cap vs small-cap funds: Key differences
When investing in equity mutual funds, investors have a choice between small-cap and large-cap funds. Both categories have their own risk-return profiles and investing rationale. Understanding the key differences between large-cap and small-cap funds can help make an informed decision while choosing the right fund.
Definition of large-cap and small-cap
In the Indian mutual fund industry, large-cap funds invest predominantly in companies ranked from 1st to 100th based on full market capitalization. These firms have established business models and are leaders in their respective industries. Some examples of large-cap companies are Reliance, HDFC Bank, TCS, Infosys etc.
On the other hand, small-cap funds allocate capital to companies ranked from 101st onwards based on market cap. Small-caps are younger firms in growth phase with market caps up to Rs. 500 crore. Some small-cap companies are Dixon, Birlasoft, Tanla Platforms etc.
Historic returns comparison
Over the long term, small-cap funds have delivered higher returns than large-cap funds. From 2012 to 2022, the average rolling returns of small-cap funds was around 22% compared to 14% for large-cap funds. However, small-cap returns are also more volatile. The outperformance makes sense given the higher risk.
Small-cap companies are fast growing and in their early life cycle. As these firms get bigger, their share prices surge rapidly. However, some small caps also fail due to competitive threats. Large caps with established businesses have more predictable earnings and lower volatility.
Small-cap equity funds come with significantly higher risk compared to large-cap funds. Some key risks are:
Business risk – Small firms have less financial resources. Any setback can impair operations and profitability.
Liquidity risk – Low trading volumes in small-cap shares leads to high volatility and liquidity issues. Exiting may require accepting deep discounts.
Governance risk – Small companies have less scrutiny. Promoters may take advantage through unfair related party deals.
Concentration risk – A small-cap portfolio has high exposure to a few stocks. Any negative event for those bets can drag down the entire fund.
In contrast, large caps have robust corporate governance, financial muscle and liquidity to tolerate downturns. Diversification across sectors reduces concentration risk. While large-cap returns may be lower, so is the risk.
Small-cap funds suit investors with an investment horizon exceeding 7 years. The additional risk pays off meaningfully over long periods as winning small caps become large firms. However, over short-term periods, small-cap volatility can lead to losses and force premature exits.
Large-cap funds are ideal for investors with lower risk appetite and shorter 2–3-year investment horizons. The large-cap segment is less volatile and allows entering/exiting without significant price erosion.
Role in portfolio
Large-cap and small-cap funds play different roles in an investor’s portfolio. Investing in large-cap mutual funds provide stability and balance the overall risk. They should form the core equity holding of a portfolio. In contrast, small-cap funds provide growth potential. Investors should allocate a small portion like 15-20% to small caps to enhance overall portfolio returns. Diversifying across both large-caps and small-caps results in a favorable risk-return payoff. This is better than just focusing on only large or small caps.
By understanding how large-cap and small-cap categories differ, investors can make the right mutual fund selections for their portfolio. Allocating prudently across market caps is key to long-term investing success. Use tools like the SIP calculator to plan your investments to perfection.